Chapter 2

Basic Cost Terminology

• Cost – resource sacrificed to achieve a specific objective

• Actual cost – a cost that has occurred

• Budgeted cost – a predicted cost

• Cost object – anything of interest for which a cost is desired

The ProductThe Product

DirectMaterials

DirectMaterials

DirectLaborDirectLabor

ManufacturingOverhead

ManufacturingOverhead

Manufacturing Costs

Further Classification of Labor Costs

Idle TimeTreated as

manufacturing overhead cost

Overtime Premium of

Factory Workers

Treated as manufacturing overhead cost

Labor Fringe Benefits

Treated as manufacturing

overhead or direct labor

Nonmanufacturing Costs

Marketing and Selling Cost

Costs necessary to get the order and deliver the

product.

Administrative Cost

All executive, organizational, and

clerical costs.

R&D

Manufacturing Cost Flows

ManufacturingOverhead

Material Purchases

Direct Labor

Balance Sheet Costs Inventories

FinishedGoods

Cost of GoodsSold

Income StatementExpenses

Selling andAdministrative

Selling andAdministrative

Period Expenses

Work in Process

Raw Material

Product Costs Versus Period Costs

Product costs include direct materials, direct

labor, and manufacturing

overhead.

Period costs are not included in product

costs. They are expensed on the

income statement.Inventory Cost of Good Sold

BalanceSheet

IncomeStatement

Sale

Expense

IncomeStatement

Balance Sheet Merchandiser Current assets

– Cash

– Receivables

– Prepaid expenses

– Merchandise inventory

Manufacturer Current Assets

Cash Receivables Prepaid Expenses Inventories

Raw Materials

Work in Process

Finished Goods

The Income Statement Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers.

Merchandising Company

Cost of goods sold: Beg. merchandise inventory 14,200$ + Purchases 234,150 Goods available for sale 248,350$ - Ending merchandise inventory (12,100) = Cost of goods sold 236,250$

Cost of Goods Manufactured

Direct Materials: Beginning Inventory, January 1 11,000$ Add: Purchases 73,000 Cost of Direct Materials Available for Use 84,000 Less: Ending Inventory, December 31 8,000 Direct Materials Used 76,000Direct Labor 9,000Manufacturing Overhead: Indirect Labor 7,000 Supplies 2,000 Heat, Light & Power 5,000 Depreciation - plant building 2,000 Depreciation - plant equipment 3,000 Miscellaneous 1,000 Total Manufacturing Overhead Costs 20,000Manufacturing costs incurred during 2007 105,000Add: Beginning WIP, January 1 6,000Total Manufacturing Costs to account for 111,000Less: Ending WIP, December 31 7,000Cost of Goods Manufactured 104,000$

Cellular ProductsSchedule of Cost of Goods Manufactured

For the Year Ended December 31, 2007 (in thousands)

Calculates the cost of Direct Materials Used

Accumulates the three product costs for the current period

Adjusts the current period manufacturing costs to account for units actually completed

Income Statement

Revenues $210,000Cost of Goods Sold Beginning Finished Goods, January 1 22,000 Cost of Goods Manufactured 104,000 Cost of Goods Available for sale 126,000 Ending Finished Goods, December 31 18,000 Cost of Goods Sold 108,000Gross Profit 102,000Operating Costs: Marketing, distribution, and customer-service 70,000 Total operating costs 70,000Operating Income $32,000

Cellular ProductsIncome Statement

For the Year Ended December 31, 2007 (in thousands) Figure carries forward from the Schedule of Cost of Goods Manufactured

Period Costs are expensed as incurred

Cost Behavior

• Variable costs – changes in total in proportion to changes in the related level of activity or volume

• Fixed costs – remain unchanged in total regardless of changes in the related level of activity or volume

• Costs are fixed or variable only with respect to a specific activity or a given time period

Cost Behavior, continued

• Variable costs – are constant on a per-unit basis. If a product takes 5 pounds of materials each, it stays the same per unit regardless of one, ten or a thousand units are produced

• Fixed costs – change inversely with the level of production. As more units are produced, the same fixed cost is spread over more and more units, reducing the cost per unit

Variable CostsVariable Costs

Total Variable Cost GraphTotal Variable Cost GraphT

otal

Cos

ts

$300,000$250,000$200,000$150,000$100,000 $50,000

10 20 300

Unit Variable Cost GraphUnit Variable Cost Graph

$20$15$10$5

0Cos

t pe

r U

nit

10 20 30

5,000 $ 50,000 $10 10,000 100,000 10 15,000 150,000 10 20,000 200,000 10 25,000 250,000 10 30,000 300,000 10

Units Total CostProduced Cost per Unit

Units Produced (000)

Units Produced (000)

Fixed CostsFixed Costs

Total Fixed Cost GraphTotal Fixed Cost GraphT

otal

Cos

ts

0

Unit Fixed Cost GraphUnit Fixed Cost Graph

Cos

t pe

r U

nit

50,000 $75,000 $1.500 100,000 75,000 .750 150,000 75,000 .500 200,000 75,000 .375 250,000 75,000 .300 300,000 75,000 .250

Units Total CostProduced Cost per Unit

$150,000$125,000$100,000$75,000$50,000

$25,000

100 200 300

$1.50$1.25$1.00$.75$.50

$.25

100 200 3000

Units Produced (000) Units Produced (000)

ExamplesAdvertising and Research and Development

ExamplesAdvertising and Research and Development

ExamplesDepreciation on Equipment and

Real Estate Taxes

ExamplesDepreciation on Equipment and

Real Estate Taxes

Types of Fixed Costs

DiscretionaryMay be altered in the short-term by current managerial decisions

DiscretionaryMay be altered in the short-term by current managerial decisions

CommittedLong-term, cannot be significantly reduced

in the short term.

CommittedLong-term, cannot be significantly reduced

in the short term.

A Cost Caveat

• Unit costs should be used cautiously. Since unit costs change with a different level of output or volume, it may be more prudent to base decisions on a total dollar basis.– Unit costs that include fixed costs should

always reference a given level of output or activity

– Unit Costs are also called Average Costs

Cost Behavior Patterns Example

Bicycles by the Sea incurs variable costs of $52 for each of its bicycles.

Bicycles by the Sea also incurs $94,500 infixed costs per year

Use Unit Costs Cautiously

What is the unit cost when Bicycles assembles 1,000 bicycles in a year?

Use Unit Costs Cautiously

Assume that Bicycles management uses aunit cost of $146.50

Management is budgeting costs fordifferent levels of production.

What is their budgeted cost for anestimated production of 600 bicycles?

600 × $146.50 = $87,900?

Use Unit Costs Cautiously

What is their budgeted cost for an estimatedproduction of 3,500 bicycles?

3,500 × $146.50 = $512,750?

Direct & Indirect Costs

• Direct costs – can be conveniently and economically traced (tracked) to a cost object

• Indirect costs – cannot be conveniently or economically traced (tracked) to a cost object. Instead of being traced, these costs are allocated to a cost object in a rational and systematic manner

Assigning Costs to Cost Objects

• Cost accumulation – a collection of cost data in an organized manner

• Cost assignment – a general term that includes associating accumulated costs with a cost object. This includes:– Tracing accumulated costs with a direct

relationship to the cost object and – Allocating accumulated costs with an indirect

relationship to a cost object

BMW: Assigning Costs to a Cost Object

Direct or Indirect?

Consider a supervisor’s salary in the canning department of Campbell Soup Company.

If the cost object is the department, the supervisor’s salary is a direct cost.

If the cost object is a can of soup (the “product” of the company), the supervisor’s salary is an indirect cost.

Relationships of Types of Costs

Direct

Indirect

Variable Fixed

Different Definitions of Costs for Different Applications

• Pricing and product-mix decisions – may use a “super” cost approach (comprehensive)

• Contracting with government agencies – very specific definitions of cost for “cost plus profit” contracts

• Preparing external-use financial statements – GAAP-driven product costs only

Additional Cost Terminology

• Variable Costs – costs that change in total in relation to some chosen activity or output

• Fixed Costs – costs that do not change in total in relation to some chosen activity or output

• Mixed Costs – costs that have both fixed and variable components; also called semivariable costs

Cost Function

La Playa Hotel offers an airlinethree alternative cost structures toaccommodate its crew overnight:

1. $60 per night per room usage

y = $60x

The slope of the cost function is $60.

Cost Function

$0

$5,000

$10,000

$15,000

$20,000

0 100 200 300

x = Number of rooms

y =

Cos

t

Cost Function

2. $8,000 per month

y = $8,000

$8,000 is called a constant or intercept.

The slope of the cost function is zero.

Cost Function

$0

$5,000

$10,000

$15,000

$20,000

0 100 200 300

x = Number of rooms

y =

Cos

t

Cost Function

3. $3,000 per month plus $24 per room

This is an example of a mixed cost.

y = $3,000 + $24x

y = a + bx

Cost Function

$0

$5,000

$10,000

$15,000

$20,000

0 100 200 300

x = Number of rooms

y =

Cos

t

The Linear Cost Function

y = a + bXThe Dependent

Variable:The cost that isbeing predicted

The IndependentVariable:

The cost driver

The Intercept:

Fixed Costs

The slope ofthe line:

variable cost per unit